“The Dying Business of Picking Stocks”

That’s the title of an interesting article in today’s Wall Street Journal on the accelerating replacement of active investing with indexing in portfolios of all stripes in the US.

One important factor in the lagging performance of most active investment groups is being left out, however. It’s the one no active investment organization wants to talk about.

Beginning in the 1980s and increasing in momentum in the 1990s, active investment groups began to dismantle their in-house investment research departments.

Why do this?

In my view it’s because,

–research departments are expensive. They’re hard to run well. Evaluating securities analysts over short periods of time, like a year, is as much an art as a science. Because of its pain-in-the-neck character, a less tha nstellar research effort is very easy to regard as an unneeded expense rather than a valuable asset

–most money management organizations are run by the chief marketing person, with the head portfolio manager being the Chief Investment Officer. So the ultimate decision maker on firm-wide administrative matters is typically not an expert on what it takes to have sustainably good investment performance

–in the 1980s and 1990s brokerage firms built and maintained strong research departments, whose output they offered to money management clients in return for charging a higher commission rate for trades. So reliable–although not proprietary–third party research was available to money managers without their having to pay for it from management fees. This added to the view that good in-house research was unnecessary

–eliminating in-house research would mean salaries “saved” that could be used to boost compensation for the professionals who remained (including the CEO and CIO, of course).

Not every firm used all the reasons on this list, but many found some combination of them persuasive enough that they decided to substantially reduce, or eliminate their independent research entirely.

This, of course, made these firms radically dependent on brokerage research…

…which has proved a disaster when, in their dark days immediately after the stock market collapse of 2008-09, most brokerage houses laid off virtually all their experienced researchers and pared back their for-commission research efforts to the bone.

This left money managers who had eliminate their own research high and dry. It also meant the affected firms were faced with the prospect of rebuilding their own in-house research. Because this would involve a substantial expansion of the professional staff, the resulting expense would pressure income for–I think–at least a couple of years.

I haven’t followed this issue carefully. My experience, though, is that this is the kind of decision CEOs really don’t want to make–to admit they were wrong, and badly enough that fixing their mistake will retard or eliminate future profit growth. As a result, a kind of paralysis sets in and the process of fixing the error never begins.